20 August 2021
The UK Government provided a wide range of financial support to UK businesses throughout the Covid-19 pandemic.
As this support begins to wind down, many companies will be facing increased risks of financial distress, whilst at the same time there is also evidence that M&A activity is on the rise. This blog explores what trustees of defined benefit (DB) pension schemes should be prepared for over the coming months.
The economic damage caused by Covid-19 prompted the Government to provide UK businesses with a wide range of financial easements. The National Audit Office estimated the total cost to the Government in supporting businesses was around £150bn (estimate as of May 2021), which represented almost 10% of GDP (gross domestic product) in 2020. UK GDP also contracted by around 10% last year, which was the largest annual reduction since the 18th century.
Despite this, UK insolvencies in 2020 were lower than any other year in the last decade, highlighting the crucial and effective role of the Government’s support mechanisms on limiting business failure. The Bank of England is projecting growth of around 7% in 2021, and although this represents a reasonable recovery, this would mean that GDP would still be lower than in 2019.
As we enter the period where Government easements wind down, what will happen to the level of corporate failures? There are several factors which are expected to create downward pressure on UK businesses, including:
- An overall contraction in GDP since 2019 reducing disposable income (which will be further impacted once the Furlough Scheme ends);
- High levels of corporate debt placing a strain on cash flows, particularly a risk if interest rates rise; and
- Continued uncertainty around Covid-19 (eg restrictions on travel, new variants, future lockdowns).
What does this mean for levels of corporate activity?
Our research suggests that there is a common cyclical trend between the level of M&A activity and corporate insolvencies.
For example, in the aftermath of the 2007/2008 global financial crisis, as insolvencies rose, so did the level of M&A activity. Similarly, following the Brexit vote in 2016, insolvencies started to increase, which was again followed quickly by a period of heightened M&A activity, albeit in the case of Brexit this was also impacted by the weakening of Sterling (effectively making it cheaper for overseas investors to purchase UK companies).
In periods of financial distress, some businesses will become vulnerable to insolvency. But where the business model is still viable and it is a liquidity / funding crisis which is causing the problem, this can lead to opportunistic investors (whether private equity, trade buyers or other investors) picking up valuable assets at low prices. So a challenging financial environment can act as a stimulus for deals.
In addition to this, there are now other factors which are contributing towards the projected spike in M&A activity, including:
- The combination of Brexit and Covid-19 reducing the value of UK companies;
- Private equity firms sitting on record levels of ‘dry powder’ – capital raised but not yet invested;
- The continued availability of cheap debt.
Supporting this narrative, estimates from Refinitiv show that private investors have bought or announced bids for almost 400 UK companies so far this year, the most for a comparable period since records began in the 1980s.
What are the implications for DB schemes?
- As financial easements end, employers of DB schemes could find themselves in greater financial distress, which will increase the likelihood of restructuring activity and insolvency.
- The probability of employers being impacted by corporate activity is increased. When considering the impact of corporate activity on their scheme, both trustees and employers (and indeed anyone involved in M&A activity) should be mindful of the changing regulatory framework and the increased powers available to the Pensions Regulator (TPR). These come from the Pension Schemes Act 2021 (PSA 2021). Certain key measures become effective from 1 October 2021, including the threat that some actions could even bring trustees, employers and others associated with DB schemes within the scope of two new criminal offences (see our Pension Schemes Act hub for further details).
- Trends are seemingly pointing towards more private equity deals, with many recent acquisitions by firms outside the UK. This can be concerning for the employer covenant with typical private equity debt structures being highly leveraged, including significantly increased secured debt which would often rank ahead of a DB pension scheme if an insolvency occurred. It can also make covenant assessment and monitoring a lot more challenging as there can be less covenant visibility on the future of the business as compared to a sponsor which may have been previously listed.
What should trustees do?
- Consider whether the frequency and scope of covenant monitoring is adequate given the heightened potential for having an employer which is in financial distress or involved in M&A activity. This would include not only the employer providing regular financial information but also informing the trustees at an early stage if certain key events occur. For example, if there is a risk of distress, trustees should be looking to hear about anticipated breaches of banking covenants or loss of a key customer as soon as possible.
- Also, and particularly important for M&A activity, trustees should consider doing some preparatory work and discussing with their employer how the process would run under various scenarios. For example, if the employer became an acquisition target, what information would the trustees need from the employer to make a comparison of the pre and post transaction covenant and negotiate from an informed position.
- Consider whether your trustee board should receive training on the PSA 2021, which is impacting the due diligence procedures around corporate activity for both corporates and trustees. We’re finding a joint sponsor and trustee training session is becoming an increasingly popular solution to ensure all stakeholders are made aware of the implications of PSA 2021.
- Trustees should consider looking to diversify their sources of covenant support where possible - this may include agreeing contingent funding solutions with sponsoring employers.
- Trustee due diligence of corporate transactions (and the covenant impact on DB Schemes) includes a combination of both financial analysis and qualitative analysis. The latter will include a broad understanding of how a company’s strategy and operations may be impacted following a change of ownership (eg change to dividend policy, intentions to divest parts of the business). This is becoming an increasingly complex area due to regulatory change, the varied approaches to tackling scheme funding and mitigation in the context of corporate activity and increased regulatory scrutiny.
Consider taking legal, covenant, actuarial and investment advice where necessary, to ensure that any impact on a scheme’s integrated risk profile because of corporate change can be quickly identified and addressed. Independent advice is particularly important in the context of corporate distress or M&A which are frequently fast moving and complex situations. LCP's covenant team has worked with trustees with pension schemes of varying sizes on the issues highlighted in this blog.
Please get in touch with one of our experts if you would like to discuss your scheme’s situation and how we can help.
 National Audit Office - Covid-19 cost tracker: https://www.nao.org.uk/covid-19/cost-tracker/
 The Guardian - UK economy hit by record slump in 2020 but double-dip recession avoided: https://www.theguardian.com/business/2021/feb/12/uk-avoided-double-dip-recession-despite-covid-slump-in-2020-ons-gdp
 Bank of England - Monetary Policy Report: https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2021/august/monetary-policy-report-august-2021.pdf
 This research was based on corporate insolvency and mergers and acquisitions data sourced from the office of national statistics, covering the period between 2009 and 2021 (up to Q1 2021).
 Financial Times - KKR steps up pursuit of UK companies amid private equity buyout frenzy: https://www.ft.com/content/e5cc18cf-081d-4b68-b469-ca77935a615e